Liquidity Services: A Small Cap with a Big Moat

When I was in university back in Australia, I found an awesome arbitrage opportunity to make some cash and took advantage of it for a year or so.

What was it?

Motorcycle apparel.

If you read my post on Tesla, you saw the picture of me and my bike. Realizing how expensive motorcycle gear was in Australia, I got onto eBay and bought all the deals I could find, shipped it over the ocean and then sold it on Australia eBay.

During this time, I came across liquidation websites like www.liquidation.com and www.govliquidation.com. Fast forward 10 years, and I just found out the sites belong to Liquidity Services (LQDT).

Bad Key Performance Indicators

Liquidity Services specialty is in wholesale, surplus and salvage assets. It’s a rare stock in the sense that it has done poorly this year.

Although member registrations has increased, the company incorrectly uses it as a Key Performance Indicator (KPI). Showing off sign ups is a vanity metric.

During fiscal year 2012, the number of registered buyers grew from approximately 1,604,000 to approximately 2,186,000, or 36.3%.

Sounds impressive, but it’s misleading.

Liquidity Services has to put that number into context. Of those sign ups, how many actually made a bid or purchased an item? That’s the KPI they should be targeting. It’s details like this that are warning signs in my book. It shows that management is measuring the wrong things on their site. It also raises questions about other parts of the business and how they are measuring it.

I don’t want to be too negative from the start so let’s begin again.

An Operator of Auction Websites

The surplus industry is very fragmented and by the size and numbers, Liquidity Services is the leader in this industry.

Buying and selling excess and salvage assets isn’t as easy as it seems. Unlike eBay where it’s simply a seller and buyer in the transaction, Liquidity Services also purchases inventory and sells it themselves or they make contracts with customers to sell on their behalf and then collects a commission when the sale goes through.

By providing a marketplace for sellers and buyers as well as offering an all-in-one solution to the bigger companies who can’t list every surplus item they have on an auction site, it’s a convenient and efficient way to offload excess inventory.

A Business with a Moat

What I like about the business is the moat. Selling big lots of slow moving inventory is a pain. If you are a seller, it’s difficult to find a buyer in your local area. It’s not something you can simply post on Craigslist and then have somebody come pick up. Liquidity Services has the network moat.

Sellers list their items with Liquidity Services because there are buyers.

Buyers buy from Liquidity Services because there are sellers.

Liquidity Services also has good customer contracts. They are the sole remarketer of the Department of Defense surplus and scrap within the United States, Puerto Rico and Guam. Their award with the Department of Defense has been renewed since 2001 and as long as performance goals are met, they shouldn’t have any trouble renewing or winning the contract bids. Especially when they are the biggest in the industry.

Acquisitions for Growth

To date, Liquidity Services has been buying out smaller auction sites to further diversify and strengthen their portfolio of auction sites and to take over business contracts.

By acquiring Jacobs Trading Company in 2011, they now own a long-term contract with Wal-Mart who made up 20% of all gross merchandise volume.

Liquidity Services operates a good business model and has a moat, but it also has some problems which shows itself in the numbers.

Troubling Numbers

The first thing you notice is that gross margins have dropped from the 90% range when it first went public to a low of 41.7% in 2012 and 39.6% TTM. Several of their business segments are seeing decreases spanning 3 years, and the drops in commodity pricing isn’t helping their scrap business.

Their SG&A varies considerably year over year. It was as high as 66% to as low as 14.6%. TTM it’s back down towards the lower end at 16.5% which is why operating margins hasn’t suffered as much.

Acquisitions are coming in faster and bigger. So far, it’s all settled with cash but if Liquidity Services is now relying on acquisitions to grow, it’s a troubling sign that they have fully tapped their local market. Buying out international public companies such as GoIndustry is also causing high expenses and complexity.

A Look at Liquidity Services Fundamentals

LQDT Valuation Ratios

As you can see, valuation needs to get better before this becomes a buy. P/B doesn’t matter for these guys because they are auctioneers. Their business model doesn’t revolve around the value of their assets.

FCF figures are distorted because of the acquisitions. The key metrics that I’m disappointed in is the ROE, ROIC and CROIC. Despite owning a moat, the operations do not reflect this. It’s merely average.

LQDT Efficiency Ratios

Another cause of concern popping up is the slowdown in sales and inventory turnover.

The high payables outstanding figure is helping to keep the cash conversion cycle negative. Companies like Liquidity Services can achieve negative cash cycles as a majority of the business is done on consignment. They don’t need to buy the inventory. Just sell it for the customers and collect the commission and fees.

LQDT Quality Scores

The Beneish score shows red but a lot of it is due to the acquisitions and volatility of sales and expenses.

What’s it Worth?

Not too concerned with trying to nail this valuation.

At the moment, the valuation multiples are too high. ROE and CROIC should be easily higher for a company like this. 12% just isn’t going to cut it.

A DCF is too much work to figure out for Liquidity Services. Using the Graham formula, EPS will likely come in around $1.30. Using a 12% growth rate, the fair value is around $26.

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